Clayton Christensen on Management and Growth

Good afternoon. So welcome to the Clarendon Management Lecture. I am thrilled to welcome Clayton Christensen to Oxford. When I was named Dean a few years ago, Clayton came up to me within a day or so and said that he had a fabulous experience at Oxford and he was hoping that he could come back someday. And I am delighted that today is that day with the first visit here at Said Business School and the ability to talk to all of you about his theories of management. I don't really need to introduce Clayton very much because that's why you're all here. You know enough about him. But he's not a slouch, let's put it that way. So summa cum laude from Brigham Young. Then went on to this place actually, a Rhodes Scholar here at Oxford, Queens. Then went to another interesting place, Harvard Business School. He was an MBA student there and graduated with high distinction. And then he took the kind of low end job of working at the White House. Along with that, he was a professor at the University of Michigan. Along the way then went back and got his doctorate, excuse me, in U.S. terms, doctorate, DBA at Harvard, worked for BCG, started up a couple of firms, wrote nine books, something like that, including one that's been noted as one of the six best business books of forever. In addition to all that, he does remarkable work in his community and in his church. And I can tell you as a colleague of his, he's a remarkable colleague as well. So triple threat, scholar, academic, educator, gentleman, everything. I am thrilled to introduce Clayton Christensen. Welcome. Thank you. Thank you. Thank you. Thank you. Well, I'm just honored that you take the time to come. Seeing so many of you here causes me to believe that it was just a boring day at Oxford. And this is all that you could find that would be partially interesting. But it's been a great opportunity for me to think through the today, tomorrow, and Wednesday and what I might offer that is new and yet wouldn't waste your time. So What I want to lay out today in one way or another is what I think might be the beginnings of a new theory of growth whose roots are at a microeconomic level, not the perspective of what an economist might view from the top down. And what I'm hoping is that the model might be useful enough that it could help us explain why some of our economies have stagnated and then also understand what can enable a nation in poverty to become prosperous. So I don't know if these will work or not, but if they're of interest to you and some of you are interested in similar things, I would love to have a chance to talk this through. over through you. So what I'm going to do for those of you who haven't suffered through a repetition of what the theory of disruption is, I'd like to just lay this out for you and then we'll come back to that for the rest of the time together. Where this came from was, as Peter mentioned, I founded several phones. firms but one of them has become quite successful and I did that before I became an academic and I brought with me a set of questions as I reflected on my own experience. A primary one was what causes successful companies to lose their growth and ultimately fail. This is the model that emerged and what I'm gonna do is describe the model in the context of a case about the steel industry. So for those of you who have not yet made a lot of steel in your lives, there are two ways to make it. Most of the world's steel historically has been made in massive integrated steel companies. It would take about ten billion dollars to build an integrated steel company today. The other way to do it is in what we call a mini mill. Mini mills melt scrap in electric furnaces. And we could put easily eight electric furnaces in this room because you can make steel of any given quality in one of these mini mills. They don't have to scale up the downstream processing steps and that's why they call these things mini mills. The most important dimension of a mini mill is that in fact you can make steel of any quality for 20% lower cost in a mini mill than you can make it in an integrated mill. So just think about this for a minute. Imagine that you were the CEO of an integrated steel company somewhere in the world. You're making commodities. Here is a technology, mini mills, that would reduce the full cost of making steel by 20%. Don't you think you'd adopt this new technology? It's broadly available. And yet not a single integrated steel company anywhere in the world has yet successfully built and operated one of these mini mills. And this is my sense for why something that makes consummate sense is actually impossible for smart people to do. So, the steel market, like every market, is comprised by tiers. At the bottom of the market is concrete reinforcing bar or rebar. Almost all of us could make rebar if we wanted to. At the high end of the market is sheet steel that's used to make appliances and cars. It's actually very hard to make that stuff. And at the beginning of this story, the integrated steel companies made the full range of these products. Mini-mills became technologically viable in the late 1960s. Because they were melting scrap in these electric furnaces, the quality that they could produce was uniformly bad. In fact, the only market that would buy what the mini mills made was the concrete reinforcing bar market because there are almost no specs for rebar anyway, and then once you buried it inside of cement you couldn't verify if it had met spec or not. And so rebar was a perfect market for crummy products. As the mini mills mini mills attacked the rebar market, the reaction of the integrated mills over there was they were just relieved to get out of the rebar. rebar business. It truly was in American English a dog-eat-dog commodity. Their gross margins were only 7%. It just didn't made no sense to defend a crummy 7% margin business when in the tier above them the integrated steel companies could generate 12% gross margins. So an interesting thing happened. As the mini mills were expanding their capacity to make rebar and the integrated steel companies got out, as they got out of rebar and added up the remaining numbers, their profitability improved by getting out. Mini mills, because they had a 20% cost advantage, they rolled tons of money by getting in. So they're quite happy one with another. But that disappeared in 1979. That was the year when the mini-mills finally succeeded in driving the last high-cost integrated player out of rebar. You look at what happened to the price of rebar in 1979. The price of rebar collapsed by 20%. It just turns out that there's a subtle fact about strategy that nobody had thought about before. And that is a low-cost strategy only works as long as you have a high-cost competitor in your market. And as soon as they had fled upmarket, then it was just low-cost mini mill fighting against low-cost mini mill in a commodity business. Very quickly competition drove prices of rebar down to the point where nobody could make money. So what are these poor mini mills gonna do? Well, they try to become efficient making rebar, but that's just a recipe for survival. And then one of them looked up market and announced, oh my gosh, if we could just make bigger and better steel, we'd make money again, because the margins there are nearly double. And so they stretched their ability from rebar into making thicker bar and rod and angle iron. As they attacked that tier of the market, the reaction to the integrated mills was they were just relieved to get out of that business because it was such a dog-eat-dog commodity and why would they ever want to defend a crummy 12% margin business when they could make 18% in structural steel. So the very same thing happened is the integrated steel companies lopped off the lowest profit part of the product line and added the remaining numbers, their profitability improved by getting out. And the mini mills, by getting in, had a 20% cost advantage again. And everything was hunky-dory on both sides until 1984. That was the year when the mini mills finally succeeded and drove the last high-cost integrated player out of angle iron, bar and rod. If you look at what happened to the price of those products in 1984, Their prices collapsed by 20% and the reward to the mini mills for their victory is they couldn't make any money. So what are these poor suckers going to do? One of them looked up and said, my gosh, if we could just even bigger and better steel, we'd make money again. And as they attacked the smallest end of the structural steam business, the reaction of the integrated mills was, man, were they happy to... get out of that business because it was such a dog-eat-dog commodity. Have I told this story before? Why would anybody ever want to defend a crummy 18% business when their margins in and sheet steel were so dramatically better. So the very same thing happened. As the integrated mills lopped off the lowest profit part of their product line and added the remaining numbers up, their profitability improved by getting out. And the mini mills, as they had a 20% cost advantage, their profitability improved by getting in to the piece that the integrated mills got out of. And things were just fine with this arrangement until 19. 1996. That was the year when the mini-mills finally succeeded in driving the last high-cost integrated player out of structural steel. What happened to those products in that year? prices collapsed by 20%. And so what's poor Nucor and the mini mills going to do? They've got to get into sheet. As they hit the commodity ends, the reaction to the integrated mills was, boy, they were happy to get out of that commodity stuff, because their margins are so much better in specialty steels. And so here we are today. The mini mills account for about 65% of North America's steel production. All but one of the integrated steel companies has gone bankrupt. Now, you notice I was able to tell the whole story without using the words stupid manager once because there's no stupidity involved on either side of the equation. Every time the integrated steel companies got out of what was less profitable, their profitability improved. And every time these guys went one stage up market, their profitability improved. And the causal mechanism behind this phenomenon... that we call the innovator's dilemma, is the pursuit of profit. So if you are a little boy and you want to kill a big giant, what does it tell you you ought to do? Well, if you think you can beat the giant by making better products that you could sell for better profits to the giant's best customers, they'll get you. But if you define a business or an approach where you come in at the bottom of them, then in pursuit of profit the giant is motivated to flee rather than fight you. And if we had several days we could go through industry by industry of how this has happened before and is going on today. Just as a simple example looking at the way you guys the clothing that you have you may not have heard of this company called Toyota. as you guys drive Lexuses and things, but Toyota didn't come into our markets with Lexuses. In fact, they came in with rusty little subcompacts in the 1960s called Coronas. And they made it finally so cheap to buy a car that the rebar of humanity, people we call college students today, can own a car. And then Toyota went from a Corona to a Tercel, Corolla, Camry, Avalon, 4Runner, Sequoia, and then a Lexus. And General Motors and Ford, who were making big cars for big people in the equivalent of integrated steel companies, they could see Toyota coming up after them through the 60s, 70s, 80s, and 90s. And every once in a while, General Motors would say, you know, we ought to go get those buggers. And so they designed a subcompact to their own that they called a Corolla. And so... a Chevy, a Chevette, or a Pinto. And it made no sense to defend the least profitable end of their business when the Americans could make even bigger cars for even bigger people. And Toyota just came underneath them and essentially killed Detroit. Who's killing Toyota? They don't feel as if they're being killed, incidentally. Kia and Hyundai, the Koreans, have stolen the bottom of the market from Toyota, not because Toyota's asleep at the switch, but why would they ever want to defend a crummy, the lowest profit part of their product line, when they have the privilege of competing in luxury cars against Mercedes? And then, right after Korea, Chevy from China... Sheree, Sheree, yeah, is doing the next. I had a stroke a couple of years ago and sometimes I just can't think of the words instantaneously, so thanks for helping me out. Anyway, so this is the model of disruption, and it explains not everything, but a lot of what goes on in our world. Now, what I'd like to do is, given that context, that people in the pursuit of profit, need to go up. I want to describe three types of innovations and then try to knit them together in a way that at least has helped me explain why our economies are stagnant. Now in America you see this, because I live there, every day. In our economy since World War II we have had nine recessions. In the first six of those nine, from the time where our economy hit bottom till when they had rebounded to achieve the prior economic peak, on average is six months, just like clockwork. But we had a recession in 1991-92-ish, where it took our economy 15 months. to achieve the prior peak. And then in 2001 and 2002, we had another recession. It took us 39 months to hit the prior peak. And now, we've been working at getting out for 67 months, and we still haven't hit the prior peak. And so there's something fundamentally wrong with our economy. And I will assert the very same problem is at work with yours and... and in Japan's as well. So the first type of disruption, of innovation that's salient to this I'll call disruptive innovation. It looks at it from a different perspective than the one I described before. I'll describe here three concentric circles and they're meant to represent populations of people. Where in the center, these are the customers in an industry who have the most money and skill. And then these larger circles represent larger populations of people who have less money and less skill. Now, almost always in an industry, it begins at the center, because the first manifestations of new technology are indeed complicated and expensive. So, in the case of computing, This first manifestation was what we call the mainframe computer. It filled a whole room. It cost about $2 million to own it and operate it, and it took years of training to operate it. And so only the largest universities and the largest corporations could have one. And therefore, it was a limited size of the market. Only the wealthy could have access. The personal computer was a disruptive technology, and I call it disruptive because it transforms what was a complicated expensive product into something that is so affordable and simple that even a poor fool like Clayton Christensen could own a computer. And if you remember those early personal computers were very limited at the beginning, and when we had a complicated problem we had to take it to the center where People who operated the mainframe helped us. But my gosh, that personal computer just got better and better and better and better. And so that more and more you can do more and more things on that personal computer and you just didn't need the mainframe nearly as much until ultimately that just disappeared. And that personal computer was pretty much all that we needed. Notice the economics were so different. These guys, $2 million, gross margins of $1.2 million per machine. The personal computer, they cost $2,000, not $2 million. dollars and that meant that the gross margins were only seven dollars, seven hundred dollars per machine. As a result the people that made the mainframe computers just like the integrated steel companies made better and better and better mainframe computers. They didn't go after this low end product because it just made no sense to go after that when the margins up here were so attractive. Then the next one. the substance was the smartphone. The cost is $200 rather than $2000 and gross margins per unit are $80. So the very same thing is at work. At the beginning you could just use the simplest problems with that machine. And so we had to do the complicated ones on our personal computer. But oh my gosh, this technology just gets better and better and better. so that more and more we can do our problems on this little device and ultimately we're just not needing the personal computer nearly as much as it was historically the case and true to form the people who make these products the personal computers like Dell, Hewlett Packard, Lenovo AsusTech they're not making these products because it makes very little sense to make something that doesn't make sense so this is the first type of technology. I'll call it disruptive innovation. And what these innovations do is they transform complicated products into simple products that are much more affordable. Now, I'm going to put those there here. The impact that disruptive innovations have is that they create jobs. Because so many more people can own and use these computers, they're more people are buying them. That means you have to hire people to make them and distribute them and sell them and service them. If you could go back into our history or yours, I'm quite certain that the data will show that nearly a hundred percent of all of the net jobs that have created in our economies in the last hundred years were created by disruptive innovations. Again by making it affordable and accessible. Now, they use capital. When you're growing, you just need to put assets on the balance sheet in order to finance that growth. So that's the first type. The second type we call sustaining innovations. And sustaining innovations, on the prior slide, were making better mainframe computers or better personal computers. Their purpose is to make good products better. And these are very important for our economy because they kept the market efficient and productive, but on average, they don't create jobs. And the reason is, when we buy a new product, we don't buy the old product. When Toyota successfully sells a Prius, the hybrid car, they don't sell a Camry. And so by their very nature, sustaining innovations... which make good products better, don't create a lot of new jobs in the economy. And because of their very nature, their replicative in character, they don't use a lot of capital either. So important, but that was the role that they played. And then the third type of innovation we're calling an efficiency innovation. Efficiency innovations allow you to sell the... the same products to the same customers but cheaper. And so Walmart is an efficiency innovation. They allow you to produce the same products to the same customers about 15% lower cost. Now when Walmart builds a store in a community, they have to hire people to work in their store. But if you look at the region, almost always the number of people in retailing is reduced because... they're so much more efficient in getting it from here to there. Now, if I go back to the mainframe mini computer discussion, when the integrated steel companies were going up market, they were investing in sustaining innovations very aggressively to make better products that they could sell for better profits to their best customers. The mini mill was an efficiency innovation. They were... they could make it. ...ton of steel with many fewer people than was required in an integrated steel company. And so the impact of efficiency innovations has is that they eliminate jobs. But importantly, they free capital. And what I mean by that is, for example, before Toyota came into North America... It took the American car companies about 60 days to assemble a car. And as it went through this turtle pace, there had to be a lot of work-in-process inventory in that factory, and that required a lot of capital to keep that on the balance sheet. When Toyota figured out what the Toyota production system was about, They reduced the cost or the time required to assemble a car from 60 days to two days. And because they did it so quickly, you just didn't have to have all of that work in process inventory on your balance sheet. And so all of that capital that had been imprisoned on the balance sheet was freed up to be used for other things. And so you could use that capital. than to invest in new disruptive innovations. And so it's almost like this works as a perpetual motion machine. As long as efficiency innovations are creating enough capital that we can launch disruptive innovations, and as long as disruptive innovations create more jobs than efficiency innovations eliminate, it just keeps going. And I would believe, my sense is that over the last 150 years in North America, our machine worked in this way. But let me mention to you something has gone wrong and this is my sense for what that in fact has gone wrong. And that is that rather than working at it as a circle, it's laid out in a straight line and the problem with the straight line is it has a beginning and an end. Where that came from was a couple of concepts. The first one was a marvelous economist named George Gilder, who just had this axiom that I described. So whenever you're making a product, you have inputs. If some of those inputs are abundant and cheap, you don't have to account for them. You can waste it if you want to. So sand, for example, is abundant and cheap and you can waste it if you need it. But other inputs might be costly and scarce. And if that's the case, then you've got to be careful. And you have to really husband the use of that product and only deploy it in applications where it will be leveraged in a maximal way. And you have to measure how efficiently you're using this scarce resource. Now, so that's kind of the paradigm that that Gilder gave to us. Now what has happened is that within our midst there is a new seminary that has emerged in our midst and I call it a seminary of new finance and this is actually a beautiful Cathedral in Reykjavik and I call it a seminary because the The students in the seminary believe in the doctrines that are being taught in this seminary as deeply as people who are religious people like I am believe in the doctrines of our churches. And the people who teach in this seminary are business professors, oddly, and partners in equity firms and so on. And this seminary emerged through the 1940s, 50s, and 60s in an era where capital was scarce and very costly. And that meant that if you're going to be good, you've got to be very careful and deploy capital only in those applications where it's going to generate the highest return. And you've got to be careful and measure. carefully this deployment of capital so that over time you only deploy it where it is most productively deployed. In order to do this, the theologians had to give us ways to measure goodness or profitability. Now prior to the Bible, Before this, managers have always needed to measure profitability in some way or another. But before these guys came on this scene, they measured profitability with crude measures like tons of cash. And now these theologians gave us sophisticated ways of measuring things and interestingly, they are all ratios and The great thing about measuring things by ratios is it gives options to managers So each ratio has a numerator and a denominator and I can go after both of those in different ways to get the number up so So for example return on on net assets is a ratio. And sure, I could make more profit and put it in the numerator of the ratio, but what the heck, I could just outsource stuff and get assets off the balance sheet to reduce the denominator in the ratio. Either way, the measure of profitability goes up. And so thank goodness these theologians gave us commandments. And interesting, they are all ratios. So I talked about RONA, which is a common ratio. EVA and ROCE are similar ratios. This is an interesting one, internal rate of return. It's a ratio where you've got profit in the numerator, if you want to take that root. The denominator, essentially, is time. And if I want to get internal rate of return to go up, then all I have to do is invest only in things that pay off in the short term. And so they gave us these sophisticated measures of measuring this scarce and costly input that we call capital. So what impact has this had on our economies? So we got this going and then out of efficiency innovations comes capital. have to decide what should I do with this capital? Well darn it, if I use that capital to invest in disruptive innovations, the problem with disruptive innovations is it pays off in five to ten years and it uses capital. So I have to put capital onto the balance sheet. What that means is if we go after this, internal rate of return goes off the cliff. and return on net assets goes off the cliff. On the other hand, guys, what if we just took this capital and spend it again into another round of efficiency capital? The great thing about this is it pays off in one to two years, and it creates more capital. And if we have more capital, then we have more options to invest. And so this comes out. And then as an analyst, because I studied this stuff in the seminary, I look at this and say, darn it, the problem with disruptive innovation is it pays off in five to ten years and it's going to use capital, darn it. On the other hand, if we just run it right back into efficiency innovations, it's going to pay off in a year or two and it's going to give us even more capital but we don't have to worry about that. we can invest. And then I go through the logic and realize what makes sense is to keep investing in efficiency innovations and more and more. And occasionally a little bit of capital goes up into disruption. But in America in the last 20 years the number of disruptive innovations that our economy has produced is about a third the number of disruptive innovations. that emerged in our economy in the 50s, 60s, and 70s. And so we are creating, taking a lot more jobs essentially out relative to the number that we're creating with disruptive innovation and that's what's wrong with our economy. If you ever want to know what the future is for Britain or America, just look at Japan because in Japan through the 1950s, 60s and 70s Remember how Japan was just a juggernaut, was growing at unprecedented rates? Well, what was happening was that they were doing disruption over and over again. And so I'll talk about some of these in a minute, but they made motorcycles affordable, that even grandmothers could have a motorcycle. Toyota did it for... Students, Sony made a television and a radio so affordable that any person could have it. Canon made copying so affordable that we could have a printer in every office. And these innovations that emanated from Toyota allowed billions of people around the world to own things and use them that previously were impossible for them to have access to it. And so their economy was growing at 6 to 10 percent per year, and if you could walk, you had a job. Their unemployment rate during those three decades was less than 2 percent. And then in the 1980s, they began to hire people who were graduates of the seminary. just like we did in America. And as they assessed the return on capital that came from that versus this, they just stopped. And since 1990, Japan's economy has generated only one disruptive innovation, that's the Nintendo Wii. But it's the only one. And so what they're doing, as what we're doing, is just... investing over and over again to create more and more capital and the result is we are awash in capital. We truly are awash in capital and the cost of capital is zero. It literally is zero. There's a company, we still create a few of these in America, there's one in the Silicon Valley called Square. They just finished their most recent private round, the cost of that equity is negative. The investors paid Square to take their money. And the head of our Federal Reserve, Ben Ankey, spends every day standing on the beach with the fire hose open full bore and he's trying to fill the ocean with capital. And I think that the Bank of England is essentially trying to do the same thing. But our world has changed. When the cost of commodity is cheap and it is abundant, you don't need to take account for it anymore. And so if we had some time, we've got some ideas for how to solve this problem, but I want to go over that to finish the other elements of the theory. But I just want to have you think about this. That if in fact the cost of capital is zero, then trying to measure and optimize the cost of capital, when capital is zero, is irrelevant. And we teach in finance that we should calculate net present value. What value is that if the cost of capital is zero? George Gilder would say is we're at a time when we could actually just waste capital. And what is scarce are investments in making our good people to become more capable people. And probably ten years down the road we will come to discover that that's the kind of thing that we need to husband because they are so scarce and so costly. Anyway, so that's one piece of the system. Now, I had a former student who returned to Japan, took a position in their industry of international trade and industry. And this poor man was sentenced to develop a plan for the resurrection of his wife. of Japan's economy. And you know, this is a big puzzle because through the 60s, 70s, and much of the 80s, Japan's economy was growing like gangbusters. And then to start 1990... It just flat-lined. And he said he worked on the problem for about two years, and he called me one day, and he said, Clay, there's no hope for Japan. And I'm a very optimistic guy, as you can tell. And I said, look, I'm certain there's something Japan can do. Why don't you just come back to Harvard, and we'll spend a day and solve Japan's problem. And what he pointed out... out after he talked with me for about an hour he convinced me that there indeed was no hope for Japan and he pointed out as just I've described to you that Japan disrupted America and they disrupted America faster they than they disrupted Western Europe because you guys have all kinds of ways to keep people out ours are more are easier to get into but those companies started at the bottom in the industries that I've described and by 1990 they were making the best products in their categories in the world. The problem with hitting the high end of the market is there's no place to go and the margins are beautiful but the volume there is limited and what happened to Japan is they stopped investing in disruption is that Korea, Taiwan, Singapore and Hong Kong started with simple products and by making them affordable and simple in a whole new section of the global economies enabled more people to have access to more interesting things and as they started to grow these guys leveled off and America got even in worse shape. Now those guys are clearly close to the top and then China comes next. They start with simple things. Now they're growing like gangbusters, but you can already feel that it's becoming mature and then India comes next. And when we laid all this out, we started to understand why this happens. Why is it that disruption itself seems to be an engine of prosperity, but also raised the question, why did these waves of disruption happen? disruption all come from China or from Asia and why hasn't Mexico disrupted America? In fact why hasn't any nation in Latin America or the Middle East or Africa become gone from poverty to prosperity in such a short time as these guys have? Why haven't they been able to disrupt their rest of us. And it's a puzzle, I'm not sure that I know the answers, but let me just describe a little bit of what we see. So Toyota, do you know where they started? This is their first product, a three wheeled delivery truck that they could use in the congested pathways in urban cities as Japan economy was trying to get out of World War II. And they started with domestic capital. This wasn't outside capital that came in, but they mustered enough capital to get going. The customers were Japanese drivers and the distribution system were Japanese as well. That's how they started. In other words, through disruption made it possible for a larger population of people now to have a car in some way or another whereas historically they didn't have access to it and then the next step was they started to fuel disruption in America by making it so affordable and accessible now that college students can do it and this is the first one that they introduced in 1962 it cost less than two thousand dollars And by creating this in America, they had to have more customers, more distributors, and so on. And then after they did that, then their focus became much more focused on sustaining innovations. That's the first, an early Camry, and then the last one is a Lexus, which I've never ridden in. In Korea, Kia started out here domestically. Domestic customers, domestic capital, domestic distribution. So affordable that almost anybody could have one. This is the first passenger car. Again, for domestic market entirely. And this one that came in 86 was the first one that they sold in the world markets. And now this is what they sell today. But again, the first step was with the domestic customers and domestic capital. This is how Kia got into the bus business. I was a missionary for the Mormon Church in Korea in the early 70s when it was the... poorest nation in Asia. And this was a bus. You just sat in the back and hopefully you got off when they hit the pothole. And this is what they do now. Think about where Honda came from. Their first product again was what they called the Cub. Essentially a motor... bicycle with a motor. Domestic customers, domestic capital, domestic dealers. And then they came, just as Toyota did, to do disruption in America and new customers, new dealers but in our nation. And you notice these are different kinds of motorcycles than normally we have thought about. And they had a... Marvelous advertising campaign called You meet the nicest people on a Honda because you didn't meet a lot of nice people on Harleys. But then after they created this new market, then they also started to focus on sustaining innovation. And just like Toyota, when it hit this transition, growth started to stop. because they're focusing not on the things that create this kind of growth here. So I don't know if you get a sense of what's going on, that in every case they have to create within themselves innovations that help them allow more people to have access to things that previously wasn't possible. And then they go up from there. This is how it happened in Taiwan. This is an interaction I'll describe quickly between a company called AsusTech and their customer Dell. At the beginning of the story, AsusTech, which is a Taiwanese car circuit guard company, came to Dell with an interesting value proposition. You know we've been doing a good job with these. Come to think of it, that motherboard Making circuit boards isn't your core competence, Dell, it's ours, and if you let us do it we could do it for 20% lower cost. Dell's analysts looked at it and realized, geez, they could. And if we had them do the motherboard, not only could the cost drop by 20%, but we could get all of the the circuit board manufacturing assets off the balance sheet because it's very capital intensive. So they shoveled that over. Dell's profitability was improved and their revenues were unaffected. AsusTech revenues and profits both improved. Then they came back a little bit later with an interesting value proposition. You know, the motherboard is really the guts of the machine. Come to think of it, Dell, you don't need to assemble all the rest of the junk because assembly isn't your core competence, it's ours. And if you let us do it, we do it for 20% lower cost. And Dell's analysts looked at it and realized Gosh, they could. And if we gave them assembly, we could get all of the other manufacturing assets off the balance sheet, and we still get $20,000. percent lower cost so they shoveled that over. Dell's revenues were unaffected but profitability improved and AsusTech's revenues and profitability improved by getting into what Dell got out of. And then Dell was visited by a Sustek people a couple of years later with an interesting value proposition. That is, you know, having to deal with all of these components, suppliers, and working out all the logistics headaches and shipping the stupid computers to you. to your dumb customers. Logistics isn't your core competence, Dell, it's ours, and if you let us do it, we could do it for 20% lower cost. Dell's analysts looked at it and realized, geez, they could. And if we gave them the supply chain, not only could they do it by 20% lower cost, but we could get all the current assets off the balance sheet. And so they shoveled that over. Dell's revenues were unaffected, but their profitability now really improved. especially return on net assets because they got no assets. And AsusTech's revenues improved by getting into what Dell got out of them. Have I told you this story before? So the very same thing happened and now AsusTech is the third largest manufacturer. of computers in the world, and Dell just puts their name on stuff that these guys make. And you notice I was able to tell the whole story without using the words stupid managers once, because there's no... stupidity involved. These guys get their profitability by getting out. These guys get their profitability by getting in. And it's the pursuit of profit that caused this to happen. But this is the mechanism by which Taiwan's economy became prosperous. As they did this over and over and over again, primarily in consumer electronics in one way or another. I'm on a board called TC in India, we started just doing simple coding and then step by step added more and more and more to the IT processes of our customers and so really it's not clear who's got what brand and parts of India have just become extraordinarily prosperous very quickly by this method of disruption. Last one, and then open for comments. There's a company in India called Gajdrej that is kind of their equivalent of Whirlpool. And the vast majority of the population in India can't afford refrigeration. And to just try to make a fridge cheaper is a problem because there's still a lot of... complication and moving parts. And so these guys actually read the theory of disruption and decided that there was another way to make a fridge. And that is they used an effect called the Peltier effect. And essentially you get a wire of bismuth and connect it to a wire of copper. And if you send the electrons through one direction, it ema... it makes it hot. If you send it in the other direction, it absorbs heat. And so they built these plastic little boxes that are insulated. And in the lid, they have these wires that use the Peltier effect, and they send it in this direction. And it can reduce the cost inside the box to about four degrees Celsius. Not cold enough to make shit. ice, but cold enough to support whatever you need in the home. And they can sell it for about 25, or I'm sorry, $35 a piece. And what's happening just in this industry is that many more people can now own and use a refrigerator. And because there's so many people who are buying them, they have to hire a lot of people to make them. And then you have to have retailers. to sell them. These are just the result of that. And then you have to have new ways of distributing these products. Actually their post office sell these things now because they're getting disrupted in the post offices as we are here. And that then enables more people to start new businesses. This is somebody who now can sell out of his shop a cold things that previously weren't possible before. And that means that more people can do more things. And so... Against all odds, 20 years ago, India has become really, pocket by pocket, and now in much more pervasive ways, a prosperous nation through disruption. Now, let me come back to Mexico. Unfortunately, what's happening in Mexico, and I don't know all the answers, is that in America, we use our capital, build factories in Mexico, on a sustaining basis. These products make our car companies make better profits in the way they're structured to make profits. We do the same thing in clothing or beauty products. Or we'll use it for efficiency innovations to make products at lower cost to then be brought back into America. But none of those creates disruptive profits. products. And what they need to do, in fact, is use domestic capital with domestic customers and domestic distribution to create new businesses in Mexico. And I've got some thoughts about why that doesn't happen. But I do think that somehow in the midst of all of that is kind of a model. And that is there have been lots of explanations about why poverty persists and what actions might or might not be levered to solve that problem. And there's a lot of logic in a lot of these. The law of law, the rule of law, investment in infrastructure that the World Bank will do for us, foreign debt, direct investment, NGO and aid. Every one of those as an explanation just doesn't, is correlative but not causal, I think. And there are counter, there are anomalies to these explanations. And somehow I just have a sense that disruption might be an element of a theory of prosperity that hasn't yet been explored in the way that it should. So one of the reasons I asked the dean to give me... me a desk to work at for a bit is those of you who have interest in this and tools to mathematically model what we're looking at, I'd be really interested. And any of the rest of you who can see anomalies from the theory would be very helpful. But anyway, this is what I wanted to share with you today is that I think that there are micro macroeconomic causes of our macroeconomic prosperity or stagnation. It's something that you would only see if you're watching how companies actually do their work as opposed to analyzing it from the level of government policies. Questions or comments or criticisms or cannonballs you want to throw at me for the next few minutes?

I don't really need to introduce Clayton very much because that's why you're all here. You know enough about him. But he's not a slouch, let's put it that way.

So summa cum laude from Brigham Young. Then went on to this place actually, a Rhodes Scholar here at Oxford, Queens. Then went to another interesting place, Harvard Business School. He was an MBA student there and graduated with high distinction.

And then he took the kind of low end job of working at the White House. Along with that, he was a professor at the University of Michigan. Along the way then went back and got his doctorate, excuse me, in U.S. terms, doctorate, DBA at Harvard, worked for BCG, started up a couple of firms, wrote nine books, something like that, including one that's been noted as one of the six best business books of forever. In addition to all that, he does remarkable work in his community and in his church.

And I can tell you as a colleague of his, he's a remarkable colleague as well. So triple threat, scholar, academic, educator, gentleman, everything. I am thrilled to introduce Clayton Christensen.

Welcome. Thank you. Thank you. Thank you. Thank you.

Well, I'm just honored that you take the time to come. Seeing so many of you here causes me to believe that it was just a boring day at Oxford. And this is all that you could find that would be partially interesting. But it's been a great opportunity for me to think through the today, tomorrow, and Wednesday and what I might offer that is new and yet wouldn't waste your time. So What I want to lay out today in one way or another is what I think might be the beginnings of a new theory of growth whose roots are at a microeconomic level, not the perspective of what an economist might view from the top down.

And what I'm hoping is that the model might be useful enough that it could help us explain why some of our economies have stagnated and then also understand what can enable a nation in poverty to become prosperous. So I don't know if these will work or not, but if they're of interest to you and some of you are interested in similar things, I would love to have a chance to talk this through. over through you. So what I'm going to do for those of you who haven't suffered through a repetition of what the theory of disruption is, I'd like to just lay this out for you and then we'll come back to that for the rest of the time together.

Where this came from was, as Peter mentioned, I founded several phones. firms but one of them has become quite successful and I did that before I became an academic and I brought with me a set of questions as I reflected on my own experience. A primary one was what causes successful companies to lose their growth and ultimately fail.

This is the model that emerged and what I'm gonna do is describe the model in the context of a case about the steel industry. So for those of you who have not yet made a lot of steel in your lives, there are two ways to make it. Most of the world's steel historically has been made in massive integrated steel companies.

It would take about ten billion dollars to build an integrated steel company today. The other way to do it is in what we call a mini mill. Mini mills melt scrap in electric furnaces. And we could put easily eight electric furnaces in this room because you can make steel of any given quality in one of these mini mills.

They don't have to scale up the downstream processing steps and that's why they call these things mini mills. The most important dimension of a mini mill is that in fact you can make steel of any quality for 20% lower cost in a mini mill than you can make it in an integrated mill. So just think about this for a minute. Imagine that you were the CEO of an integrated steel company somewhere in the world. You're making commodities.

Here is a technology, mini mills, that would reduce the full cost of making steel by 20%. Don't you think you'd adopt this new technology? It's broadly available. And yet not a single integrated steel company anywhere in the world has yet successfully built and operated one of these mini mills. And this is my sense for why something that makes consummate sense is actually impossible for smart people to do.

So, the steel market, like every market, is comprised by tiers. At the bottom of the market is concrete reinforcing bar or rebar. Almost all of us could make rebar if we wanted to.

At the high end of the market is sheet steel that's used to make appliances and cars. It's actually very hard to make that stuff. And at the beginning of this story, the integrated steel companies made the full range of these products. Mini-mills became technologically viable in the late 1960s.

Because they were melting scrap in these electric furnaces, the quality that they could produce was uniformly bad. In fact, the only market that would buy what the mini mills made was the concrete reinforcing bar market because there are almost no specs for rebar anyway, and then once you buried it inside of cement you couldn't verify if it had met spec or not. And so rebar was a perfect market for crummy products. As the mini mills mini mills attacked the rebar market, the reaction of the integrated mills over there was they were just relieved to get out of the rebar.

rebar business. It truly was in American English a dog-eat-dog commodity. Their gross margins were only 7%. It just didn't made no sense to defend a crummy 7% margin business when in the tier above them the integrated steel companies could generate 12% gross margins.

So an interesting thing happened. As the mini mills were expanding their capacity to make rebar and the integrated steel companies got out, as they got out of rebar and added up the remaining numbers, their profitability improved by getting out. Mini mills, because they had a 20% cost advantage, they rolled tons of money by getting in. So they're quite happy one with another.

But that disappeared in 1979. That was the year when the mini-mills finally succeeded in driving the last high-cost integrated player out of rebar. You look at what happened to the price of rebar in 1979. The price of rebar collapsed by 20%. It just turns out that there's a subtle fact about strategy that nobody had thought about before.

And that is a low-cost strategy only works as long as you have a high-cost competitor in your market. And as soon as they had fled upmarket, then it was just low-cost mini mill fighting against low-cost mini mill in a commodity business. Very quickly competition drove prices of rebar down to the point where nobody could make money.

So what are these poor mini mills gonna do? Well, they try to become efficient making rebar, but that's just a recipe for survival. And then one of them looked up market and announced, oh my gosh, if we could just make bigger and better steel, we'd make money again, because the margins there are nearly double.

And so they stretched their ability from rebar into making thicker bar and rod and angle iron. As they attacked that tier of the market, the reaction to the integrated mills was they were just relieved to get out of that business because it was such a dog-eat-dog commodity and why would they ever want to defend a crummy 12% margin business when they could make 18% in structural steel. So the very same thing happened is the integrated steel companies lopped off the lowest profit part of the product line and added the remaining numbers, their profitability improved by getting out. And the mini mills, by getting in, had a 20% cost advantage again. And everything was hunky-dory on both sides until 1984. That was the year when the mini mills finally succeeded and drove the last high-cost integrated player out of angle iron, bar and rod.

If you look at what happened to the price of those products in 1984, Their prices collapsed by 20% and the reward to the mini mills for their victory is they couldn't make any money. So what are these poor suckers going to do? One of them looked up and said, my gosh, if we could just even bigger and better steel, we'd make money again. And as they attacked the smallest end of the structural steam business, the reaction of the integrated mills was, man, were they happy to... get out of that business because it was such a dog-eat-dog commodity.

Have I told this story before? Why would anybody ever want to defend a crummy 18% business when their margins in and sheet steel were so dramatically better. So the very same thing happened.

As the integrated mills lopped off the lowest profit part of their product line and added the remaining numbers up, their profitability improved by getting out. And the mini mills, as they had a 20% cost advantage, their profitability improved by getting in to the piece that the integrated mills got out of. And things were just fine with this arrangement until 19. 1996. That was the year when the mini-mills finally succeeded in driving the last high-cost integrated player out of structural steel.

What happened to those products in that year? prices collapsed by 20%. And so what's poor Nucor and the mini mills going to do?

They've got to get into sheet. As they hit the commodity ends, the reaction to the integrated mills was, boy, they were happy to get out of that commodity stuff, because their margins are so much better in specialty steels. And so here we are today. The mini mills account for about 65% of North America's steel production. All but one of the integrated steel companies has gone bankrupt.

Now, you notice I was able to tell the whole story without using the words stupid manager once because there's no stupidity involved on either side of the equation. Every time the integrated steel companies got out of what was less profitable, their profitability improved. And every time these guys went one stage up market, their profitability improved.

And the causal mechanism behind this phenomenon... that we call the innovator's dilemma, is the pursuit of profit. So if you are a little boy and you want to kill a big giant, what does it tell you you ought to do?

Well, if you think you can beat the giant by making better products that you could sell for better profits to the giant's best customers, they'll get you. But if you define a business or an approach where you come in at the bottom of them, then in pursuit of profit the giant is motivated to flee rather than fight you. And if we had several days we could go through industry by industry of how this has happened before and is going on today. Just as a simple example looking at the way you guys the clothing that you have you may not have heard of this company called Toyota. as you guys drive Lexuses and things, but Toyota didn't come into our markets with Lexuses.

In fact, they came in with rusty little subcompacts in the 1960s called Coronas. And they made it finally so cheap to buy a car that the rebar of humanity, people we call college students today, can own a car. And then Toyota went from a Corona to a Tercel, Corolla, Camry, Avalon, 4Runner, Sequoia, and then a Lexus. And General Motors and Ford, who were making big cars for big people in the equivalent of integrated steel companies, they could see Toyota coming up after them through the 60s, 70s, 80s, and 90s.

And every once in a while, General Motors would say, you know, we ought to go get those buggers. And so they designed a subcompact to their own that they called a Corolla. And so...

a Chevy, a Chevette, or a Pinto. And it made no sense to defend the least profitable end of their business when the Americans could make even bigger cars for even bigger people. And Toyota just came underneath them and essentially killed Detroit. Who's killing Toyota?

They don't feel as if they're being killed, incidentally. Kia and Hyundai, the Koreans, have stolen the bottom of the market from Toyota, not because Toyota's asleep at the switch, but why would they ever want to defend a crummy, the lowest profit part of their product line, when they have the privilege of competing in luxury cars against Mercedes? And then, right after Korea, Chevy from China... Sheree, Sheree, yeah, is doing the next. I had a stroke a couple of years ago and sometimes I just can't think of the words instantaneously, so thanks for helping me out.

Anyway, so this is the model of disruption, and it explains not everything, but a lot of what goes on in our world. Now, what I'd like to do is, given that context, that people in the pursuit of profit, need to go up. I want to describe three types of innovations and then try to knit them together in a way that at least has helped me explain why our economies are stagnant.

Now in America you see this, because I live there, every day. In our economy since World War II we have had nine recessions. In the first six of those nine, from the time where our economy hit bottom till when they had rebounded to achieve the prior economic peak, on average is six months, just like clockwork.

But we had a recession in 1991-92-ish, where it took our economy 15 months. to achieve the prior peak. And then in 2001 and 2002, we had another recession. It took us 39 months to hit the prior peak. And now, we've been working at getting out for 67 months, and we still haven't hit the prior peak.

And so there's something fundamentally wrong with our economy. And I will assert the very same problem is at work with yours and... and in Japan's as well. So the first type of disruption, of innovation that's salient to this I'll call disruptive innovation.

It looks at it from a different perspective than the one I described before. I'll describe here three concentric circles and they're meant to represent populations of people. Where in the center, these are the customers in an industry who have the most money and skill.

And then these larger circles represent larger populations of people who have less money and less skill. Now, almost always in an industry, it begins at the center, because the first manifestations of new technology are indeed complicated and expensive. So, in the case of computing, This first manifestation was what we call the mainframe computer. It filled a whole room.

It cost about $2 million to own it and operate it, and it took years of training to operate it. And so only the largest universities and the largest corporations could have one. And therefore, it was a limited size of the market.

Only the wealthy could have access. The personal computer was a disruptive technology, and I call it disruptive because it transforms what was a complicated expensive product into something that is so affordable and simple that even a poor fool like Clayton Christensen could own a computer. And if you remember those early personal computers were very limited at the beginning, and when we had a complicated problem we had to take it to the center where People who operated the mainframe helped us. But my gosh, that personal computer just got better and better and better and better.

And so that more and more you can do more and more things on that personal computer and you just didn't need the mainframe nearly as much until ultimately that just disappeared. And that personal computer was pretty much all that we needed. Notice the economics were so different.

These guys, $2 million, gross margins of $1.2 million per machine. The personal computer, they cost $2,000, not $2 million. dollars and that meant that the gross margins were only seven dollars, seven hundred dollars per machine.

As a result the people that made the mainframe computers just like the integrated steel companies made better and better and better mainframe computers. They didn't go after this low end product because it just made no sense to go after that when the margins up here were so attractive. Then the next one.

the substance was the smartphone. The cost is $200 rather than $2000 and gross margins per unit are $80. So the very same thing is at work.

At the beginning you could just use the simplest problems with that machine. And so we had to do the complicated ones on our personal computer. But oh my gosh, this technology just gets better and better and better. so that more and more we can do our problems on this little device and ultimately we're just not needing the personal computer nearly as much as it was historically the case and true to form the people who make these products the personal computers like Dell, Hewlett Packard, Lenovo AsusTech they're not making these products because it makes very little sense to make something that doesn't make sense so this is the first type of technology.

I'll call it disruptive innovation. And what these innovations do is they transform complicated products into simple products that are much more affordable. Now, I'm going to put those there here.

The impact that disruptive innovations have is that they create jobs. Because so many more people can own and use these computers, they're more people are buying them. That means you have to hire people to make them and distribute them and sell them and service them.

If you could go back into our history or yours, I'm quite certain that the data will show that nearly a hundred percent of all of the net jobs that have created in our economies in the last hundred years were created by disruptive innovations. Again by making it affordable and accessible. Now, they use capital.

When you're growing, you just need to put assets on the balance sheet in order to finance that growth. So that's the first type. The second type we call sustaining innovations. And sustaining innovations, on the prior slide, were making better mainframe computers or better personal computers. Their purpose is to make good products better.

And these are very important for our economy because they kept the market efficient and productive, but on average, they don't create jobs. And the reason is, when we buy a new product, we don't buy the old product. When Toyota successfully sells a Prius, the hybrid car, they don't sell a Camry. And so by their very nature, sustaining innovations...

which make good products better, don't create a lot of new jobs in the economy. And because of their very nature, their replicative in character, they don't use a lot of capital either. So important, but that was the role that they played.

And then the third type of innovation we're calling an efficiency innovation. Efficiency innovations allow you to sell the... the same products to the same customers but cheaper.

And so Walmart is an efficiency innovation. They allow you to produce the same products to the same customers about 15% lower cost. Now when Walmart builds a store in a community, they have to hire people to work in their store.

But if you look at the region, almost always the number of people in retailing is reduced because... they're so much more efficient in getting it from here to there. Now, if I go back to the mainframe mini computer discussion, when the integrated steel companies were going up market, they were investing in sustaining innovations very aggressively to make better products that they could sell for better profits to their best customers.

The mini mill was an efficiency innovation. They were... they could make it.

...ton of steel with many fewer people than was required in an integrated steel company. And so the impact of efficiency innovations has is that they eliminate jobs. But importantly, they free capital. And what I mean by that is, for example, before Toyota came into North America...

It took the American car companies about 60 days to assemble a car. And as it went through this turtle pace, there had to be a lot of work-in-process inventory in that factory, and that required a lot of capital to keep that on the balance sheet. When Toyota figured out what the Toyota production system was about, They reduced the cost or the time required to assemble a car from 60 days to two days. And because they did it so quickly, you just didn't have to have all of that work in process inventory on your balance sheet. And so all of that capital that had been imprisoned on the balance sheet was freed up to be used for other things.

And so you could use that capital. than to invest in new disruptive innovations. And so it's almost like this works as a perpetual motion machine.

As long as efficiency innovations are creating enough capital that we can launch disruptive innovations, and as long as disruptive innovations create more jobs than efficiency innovations eliminate, it just keeps going. And I would believe, my sense is that over the last 150 years in North America, our machine worked in this way. But let me mention to you something has gone wrong and this is my sense for what that in fact has gone wrong.

And that is that rather than working at it as a circle, it's laid out in a straight line and the problem with the straight line is it has a beginning and an end. Where that came from was a couple of concepts. The first one was a marvelous economist named George Gilder, who just had this axiom that I described.

So whenever you're making a product, you have inputs. If some of those inputs are abundant and cheap, you don't have to account for them. You can waste it if you want to. So sand, for example, is abundant and cheap and you can waste it if you need it.

But other inputs might be costly and scarce. And if that's the case, then you've got to be careful. And you have to really husband the use of that product and only deploy it in applications where it will be leveraged in a maximal way. And you have to measure how efficiently you're using this scarce resource.

Now, so that's kind of the paradigm that that Gilder gave to us. Now what has happened is that within our midst there is a new seminary that has emerged in our midst and I call it a seminary of new finance and this is actually a beautiful Cathedral in Reykjavik and I call it a seminary because the The students in the seminary believe in the doctrines that are being taught in this seminary as deeply as people who are religious people like I am believe in the doctrines of our churches. And the people who teach in this seminary are business professors, oddly, and partners in equity firms and so on. And this seminary emerged through the 1940s, 50s, and 60s in an era where capital was scarce and very costly.

And that meant that if you're going to be good, you've got to be very careful and deploy capital only in those applications where it's going to generate the highest return. And you've got to be careful and measure. carefully this deployment of capital so that over time you only deploy it where it is most productively deployed.

In order to do this, the theologians had to give us ways to measure goodness or profitability. Now prior to the Bible, Before this, managers have always needed to measure profitability in some way or another. But before these guys came on this scene, they measured profitability with crude measures like tons of cash.

And now these theologians gave us sophisticated ways of measuring things and interestingly, they are all ratios and The great thing about measuring things by ratios is it gives options to managers So each ratio has a numerator and a denominator and I can go after both of those in different ways to get the number up so So for example return on on net assets is a ratio. And sure, I could make more profit and put it in the numerator of the ratio, but what the heck, I could just outsource stuff and get assets off the balance sheet to reduce the denominator in the ratio. Either way, the measure of profitability goes up.

And so thank goodness these theologians gave us commandments. And interesting, they are all ratios. So I talked about RONA, which is a common ratio. EVA and ROCE are similar ratios. This is an interesting one, internal rate of return.

It's a ratio where you've got profit in the numerator, if you want to take that root. The denominator, essentially, is time. And if I want to get internal rate of return to go up, then all I have to do is invest only in things that pay off in the short term. And so they gave us these sophisticated measures of measuring this scarce and costly input that we call capital. So what impact has this had on our economies?

So we got this going and then out of efficiency innovations comes capital. have to decide what should I do with this capital? Well darn it, if I use that capital to invest in disruptive innovations, the problem with disruptive innovations is it pays off in five to ten years and it uses capital. So I have to put capital onto the balance sheet. What that means is if we go after this, internal rate of return goes off the cliff.

and return on net assets goes off the cliff. On the other hand, guys, what if we just took this capital and spend it again into another round of efficiency capital? The great thing about this is it pays off in one to two years, and it creates more capital. And if we have more capital, then we have more options to invest. And so this comes out.

And then as an analyst, because I studied this stuff in the seminary, I look at this and say, darn it, the problem with disruptive innovation is it pays off in five to ten years and it's going to use capital, darn it. On the other hand, if we just run it right back into efficiency innovations, it's going to pay off in a year or two and it's going to give us even more capital but we don't have to worry about that. we can invest. And then I go through the logic and realize what makes sense is to keep investing in efficiency innovations and more and more.

And occasionally a little bit of capital goes up into disruption. But in America in the last 20 years the number of disruptive innovations that our economy has produced is about a third the number of disruptive innovations. that emerged in our economy in the 50s, 60s, and 70s.

And so we are creating, taking a lot more jobs essentially out relative to the number that we're creating with disruptive innovation and that's what's wrong with our economy. If you ever want to know what the future is for Britain or America, just look at Japan because in Japan through the 1950s, 60s and 70s Remember how Japan was just a juggernaut, was growing at unprecedented rates? Well, what was happening was that they were doing disruption over and over again. And so I'll talk about some of these in a minute, but they made motorcycles affordable, that even grandmothers could have a motorcycle.

Toyota did it for... Students, Sony made a television and a radio so affordable that any person could have it. Canon made copying so affordable that we could have a printer in every office. And these innovations that emanated from Toyota allowed billions of people around the world to own things and use them that previously were impossible for them to have access to it. And so their economy was growing at 6 to 10 percent per year, and if you could walk, you had a job.

Their unemployment rate during those three decades was less than 2 percent. And then in the 1980s, they began to hire people who were graduates of the seminary. just like we did in America.

And as they assessed the return on capital that came from that versus this, they just stopped. And since 1990, Japan's economy has generated only one disruptive innovation, that's the Nintendo Wii. But it's the only one.

And so what they're doing, as what we're doing, is just... investing over and over again to create more and more capital and the result is we are awash in capital. We truly are awash in capital and the cost of capital is zero.

It literally is zero. There's a company, we still create a few of these in America, there's one in the Silicon Valley called Square. They just finished their most recent private round, the cost of that equity is negative.

The investors paid Square to take their money. And the head of our Federal Reserve, Ben Ankey, spends every day standing on the beach with the fire hose open full bore and he's trying to fill the ocean with capital. And I think that the Bank of England is essentially trying to do the same thing.

But our world has changed. When the cost of commodity is cheap and it is abundant, you don't need to take account for it anymore. And so if we had some time, we've got some ideas for how to solve this problem, but I want to go over that to finish the other elements of the theory.

But I just want to have you think about this. That if in fact the cost of capital is zero, then trying to measure and optimize the cost of capital, when capital is zero, is irrelevant. And we teach in finance that we should calculate net present value.

What value is that if the cost of capital is zero? George Gilder would say is we're at a time when we could actually just waste capital. And what is scarce are investments in making our good people to become more capable people. And probably ten years down the road we will come to discover that that's the kind of thing that we need to husband because they are so scarce and so costly. Anyway, so that's one piece of the system.

Now, I had a former student who returned to Japan, took a position in their industry of international trade and industry. And this poor man was sentenced to develop a plan for the resurrection of his wife. of Japan's economy. And you know, this is a big puzzle because through the 60s, 70s, and much of the 80s, Japan's economy was growing like gangbusters. And then to start 1990...

It just flat-lined. And he said he worked on the problem for about two years, and he called me one day, and he said, Clay, there's no hope for Japan. And I'm a very optimistic guy, as you can tell. And I said, look, I'm certain there's something Japan can do. Why don't you just come back to Harvard, and we'll spend a day and solve Japan's problem.

And what he pointed out... out after he talked with me for about an hour he convinced me that there indeed was no hope for Japan and he pointed out as just I've described to you that Japan disrupted America and they disrupted America faster they than they disrupted Western Europe because you guys have all kinds of ways to keep people out ours are more are easier to get into but those companies started at the bottom in the industries that I've described and by 1990 they were making the best products in their categories in the world. The problem with hitting the high end of the market is there's no place to go and the margins are beautiful but the volume there is limited and what happened to Japan is they stopped investing in disruption is that Korea, Taiwan, Singapore and Hong Kong started with simple products and by making them affordable and simple in a whole new section of the global economies enabled more people to have access to more interesting things and as they started to grow these guys leveled off and America got even in worse shape. Now those guys are clearly close to the top and then China comes next. They start with simple things.

Now they're growing like gangbusters, but you can already feel that it's becoming mature and then India comes next. And when we laid all this out, we started to understand why this happens. Why is it that disruption itself seems to be an engine of prosperity, but also raised the question, why did these waves of disruption happen?

disruption all come from China or from Asia and why hasn't Mexico disrupted America? In fact why hasn't any nation in Latin America or the Middle East or Africa become gone from poverty to prosperity in such a short time as these guys have? Why haven't they been able to disrupt their rest of us.

And it's a puzzle, I'm not sure that I know the answers, but let me just describe a little bit of what we see. So Toyota, do you know where they started? This is their first product, a three wheeled delivery truck that they could use in the congested pathways in urban cities as Japan economy was trying to get out of World War II. And they started with domestic capital. This wasn't outside capital that came in, but they mustered enough capital to get going.

The customers were Japanese drivers and the distribution system were Japanese as well. That's how they started. In other words, through disruption made it possible for a larger population of people now to have a car in some way or another whereas historically they didn't have access to it and then the next step was they started to fuel disruption in America by making it so affordable and accessible now that college students can do it and this is the first one that they introduced in 1962 it cost less than two thousand dollars And by creating this in America, they had to have more customers, more distributors, and so on.

And then after they did that, then their focus became much more focused on sustaining innovations. That's the first, an early Camry, and then the last one is a Lexus, which I've never ridden in. In Korea, Kia started out here domestically.

Domestic customers, domestic capital, domestic distribution. So affordable that almost anybody could have one. This is the first passenger car.

Again, for domestic market entirely. And this one that came in 86 was the first one that they sold in the world markets. And now this is what they sell today.

But again, the first step was with the domestic customers and domestic capital. This is how Kia got into the bus business. I was a missionary for the Mormon Church in Korea in the early 70s when it was the...

poorest nation in Asia. And this was a bus. You just sat in the back and hopefully you got off when they hit the pothole. And this is what they do now.

Think about where Honda came from. Their first product again was what they called the Cub. Essentially a motor... bicycle with a motor. Domestic customers, domestic capital, domestic dealers.

And then they came, just as Toyota did, to do disruption in America and new customers, new dealers but in our nation. And you notice these are different kinds of motorcycles than normally we have thought about. And they had a...

Marvelous advertising campaign called You meet the nicest people on a Honda because you didn't meet a lot of nice people on Harleys. But then after they created this new market, then they also started to focus on sustaining innovation. And just like Toyota, when it hit this transition, growth started to stop.

because they're focusing not on the things that create this kind of growth here. So I don't know if you get a sense of what's going on, that in every case they have to create within themselves innovations that help them allow more people to have access to things that previously wasn't possible. And then they go up from there. This is how it happened in Taiwan. This is an interaction I'll describe quickly between a company called AsusTech and their customer Dell.

At the beginning of the story, AsusTech, which is a Taiwanese car circuit guard company, came to Dell with an interesting value proposition. You know we've been doing a good job with these. Come to think of it, that motherboard Making circuit boards isn't your core competence, Dell, it's ours, and if you let us do it we could do it for 20% lower cost.

Dell's analysts looked at it and realized, geez, they could. And if we had them do the motherboard, not only could the cost drop by 20%, but we could get all of the the circuit board manufacturing assets off the balance sheet because it's very capital intensive. So they shoveled that over. Dell's profitability was improved and their revenues were unaffected. AsusTech revenues and profits both improved.

Then they came back a little bit later with an interesting value proposition. You know, the motherboard is really the guts of the machine. Come to think of it, Dell, you don't need to assemble all the rest of the junk because assembly isn't your core competence, it's ours.

And if you let us do it, we do it for 20% lower cost. And Dell's analysts looked at it and realized Gosh, they could. And if we gave them assembly, we could get all of the other manufacturing assets off the balance sheet, and we still get $20,000.

percent lower cost so they shoveled that over. Dell's revenues were unaffected but profitability improved and AsusTech's revenues and profitability improved by getting into what Dell got out of. And then Dell was visited by a Sustek people a couple of years later with an interesting value proposition.

That is, you know, having to deal with all of these components, suppliers, and working out all the logistics headaches and shipping the stupid computers to you. to your dumb customers. Logistics isn't your core competence, Dell, it's ours, and if you let us do it, we could do it for 20% lower cost.

Dell's analysts looked at it and realized, geez, they could. And if we gave them the supply chain, not only could they do it by 20% lower cost, but we could get all the current assets off the balance sheet. And so they shoveled that over. Dell's revenues were unaffected, but their profitability now really improved. especially return on net assets because they got no assets.

And AsusTech's revenues improved by getting into what Dell got out of them. Have I told you this story before? So the very same thing happened and now AsusTech is the third largest manufacturer.

of computers in the world, and Dell just puts their name on stuff that these guys make. And you notice I was able to tell the whole story without using the words stupid managers once, because there's no... stupidity involved. These guys get their profitability by getting out.

These guys get their profitability by getting in. And it's the pursuit of profit that caused this to happen. But this is the mechanism by which Taiwan's economy became prosperous.

As they did this over and over and over again, primarily in consumer electronics in one way or another. I'm on a board called TC in India, we started just doing simple coding and then step by step added more and more and more to the IT processes of our customers and so really it's not clear who's got what brand and parts of India have just become extraordinarily prosperous very quickly by this method of disruption. Last one, and then open for comments.

There's a company in India called Gajdrej that is kind of their equivalent of Whirlpool. And the vast majority of the population in India can't afford refrigeration. And to just try to make a fridge cheaper is a problem because there's still a lot of... complication and moving parts.

And so these guys actually read the theory of disruption and decided that there was another way to make a fridge. And that is they used an effect called the Peltier effect. And essentially you get a wire of bismuth and connect it to a wire of copper. And if you send the electrons through one direction, it ema... it makes it hot.

If you send it in the other direction, it absorbs heat. And so they built these plastic little boxes that are insulated. And in the lid, they have these wires that use the Peltier effect, and they send it in this direction. And it can reduce the cost inside the box to about four degrees Celsius.

Not cold enough to make shit. ice, but cold enough to support whatever you need in the home. And they can sell it for about 25, or I'm sorry, $35 a piece. And what's happening just in this industry is that many more people can now own and use a refrigerator.

And because there's so many people who are buying them, they have to hire a lot of people to make them. And then you have to have retailers. to sell them.

These are just the result of that. And then you have to have new ways of distributing these products. Actually their post office sell these things now because they're getting disrupted in the post offices as we are here. And that then enables more people to start new businesses. This is somebody who now can sell out of his shop a cold things that previously weren't possible before.

And that means that more people can do more things. And so... Against all odds, 20 years ago, India has become really, pocket by pocket, and now in much more pervasive ways, a prosperous nation through disruption.

Now, let me come back to Mexico. Unfortunately, what's happening in Mexico, and I don't know all the answers, is that in America, we use our capital, build factories in Mexico, on a sustaining basis. These products make our car companies make better profits in the way they're structured to make profits. We do the same thing in clothing or beauty products. Or we'll use it for efficiency innovations to make products at lower cost to then be brought back into America.

But none of those creates disruptive profits. products. And what they need to do, in fact, is use domestic capital with domestic customers and domestic distribution to create new businesses in Mexico.

And I've got some thoughts about why that doesn't happen. But I do think that somehow in the midst of all of that is kind of a model. And that is there have been lots of explanations about why poverty persists and what actions might or might not be levered to solve that problem.

And there's a lot of logic in a lot of these. The law of law, the rule of law, investment in infrastructure that the World Bank will do for us, foreign debt, direct investment, NGO and aid. Every one of those as an explanation just doesn't, is correlative but not causal, I think.

And there are counter, there are anomalies to these explanations. And somehow I just have a sense that disruption might be an element of a theory of prosperity that hasn't yet been explored in the way that it should. So one of the reasons I asked the dean to give me...

me a desk to work at for a bit is those of you who have interest in this and tools to mathematically model what we're looking at, I'd be really interested. And any of the rest of you who can see anomalies from the theory would be very helpful. But anyway, this is what I wanted to share with you today is that I think that there are micro macroeconomic causes of our macroeconomic prosperity or stagnation. It's something that you would only see if you're watching how companies actually do their work as opposed to analyzing it from the level of government policies. Questions or comments or criticisms or cannonballs you want to throw at me for the next few minutes?

Transcript for:Clayton Christensen on Management and Growth

Transcript for:
Clayton Christensen on Management and Growth